One day after the FOMC (Federal Open Market Committee) Meeting, it was the Bank of England (BOE)’s turn to decide on the level of interest rate and the overall monetary policy decision in the United Kingdom (U.K). No changes from the BOE, but the market participants were shocked to hear that the bank is actively studying negative rates.
This is the second time since the BOE suggests it might move the rate below zero. The first time it did, the Great Britain Pound (GBP) reacted strongly, albeit only for a short period of time. Yesterday’s reaction was mixed – after dropping initially, the GBP recovered the lost ground and, in some cases, even gained on the day.
Bank of England’s Inflation Letter
What the BOE did has a name in the financial world – trial balloons. Every time a central bank wants to see the potential effect of a new or unconventional monetary policy, it uses such “balloons.” First, they come in the form of a simple mentioning of the bank’s intention. Usually, the first communication appears in a low-profile event, such as a speech or interview – something unrelated to the main scheduled monetary policy event.
Up next is to mention the intention in the official monetary policy report. Finally, implementation ends the process. So far, this is exactly what the BOE did. In other words, it would be a surprise not to see the bank moving the rates below zero in the not so distant future.
Yesterday, the BOE decided to keep the monetary policy unchanged. It followed in the footsteps of other major central banks in different jurisdictions (e.g., the Fed, the ECB, the RBA), and the preferred way at this meeting was a wait-and-see approach.
The current bank rate is just shy above zero. Sitting at 0.1%, it is accompanied by a quantitative easing package of GBP745 billion. Inflation in the United Kingdom currently sits at 0.2% – way below the 2% target, and it represents the main reason for the BOE’s announcement about studying negative interest rates.
If and when inflation moves away from the target by more than a percentage point, the Governor must send a letter to the Chancellor explaining why this is happening. The so-called Inflation Letter gives the market the opportunity to find out the BOE’s thoughts after a meeting where it does not change its monetary policy.
Yesterday’s letter painted a bleak outlook for both inflation and the U.K’s economy. If we add to this the Brexit uncertainty, we understand why the BOE stands ready to make such a controversial decision – moving the interest rate into negative territory.